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Abstract:

We derive new estimates of total wealth, the returns on total wealth, and the wealth effect on consumption. We estimate the prices of aggregate risk from bond yields and stock returns using a no-arbitrage model. Using these risk prices, we compute total wealth as the price of a claim to aggregate consumption. We find that US households have a surprising amount of total wealth, most of it human wealth. This wealth is much less risky than stock market wealth. Events in long-term bond markets, not stock markets, drive most total wealth fluctuations. The wealth effect on consumption is small and varies over time with real interest rates.

This paper analyzes and computes the equilibria of economies with large numbers of heterogeneous agents who have different asset trading technologies, preferences and beliefs. We illustrate the value of our method by using it to evaluate the implications of these heterogeneities through several quantitative exercises.

Abstract: We describe a novel currency investment strategy, the `dollar carry trade,' which delivers large excess returns, uncorrelated with the returns on well-known carry trade strategies. Using a no-arbitrage model of exchange rates we show that these excess returns compensate U.S. investors for taking on aggregate risk by shorting the dollar in bad times, when the price of risk is high. The counter-cyclical variation in risk premia leads to strong return predictability: the average forward discount and U.S. industrial production growth rates forecast up to 25% of the dollar return variation at the one-year horizon.

Abstract: In the US and other OECD countries, expected returns on stocks, adjusted for volatility, are much higher in recessions than in expansions. To compute a measure of expected returns, we consider feasible trading strategies that buy or sell shortly after business cycle turning points that are identifiable in real-time and that involve holding periods of up to a year. The changes in expected returns during business cycle expansions and contractions that we identify are not spuriously driven by changes in expected near-term dividend growth. Our findings imply that firm-value-maximizing managers face much higher risk-adjusted costs of capital in their investment decisions during recessions than expansions

Abstract: The largest commercial bank stocks have significantly lower risk-adjusted returns than small- and medium-sized bank stocks, even though large banks are significantly more levered. We uncover a size factor in the component of bank returns that is orthogonal to the standard risk factors, including small-minus-big, which has the right covariance with bank returns to explain the average risk-adjusted returns. This factor measures size-dependent exposure to bank-specific tail risk. These findings are consistent with the existence of government guarantees that protect shareholders of large banks in disaster states. A general equilibrium model with rare bank disasters can match these alphas in a sample without disasters provided that the difference in disaster recovery rates between the largest and smallest banks is at least 35 cents per dollar of dividends.

Abstract: We show that the price of a Treasury bond and an inflation-swapped TIPS issue exactly replicating the cash flows of the Treasury bond can differ by more than $20 per $100 notional. Treasury bonds are almost always overvalued relative to TIPS. Total TIPS–Treasury mispricing has exceeded $56 billion, representing nearly 8\% of the total amount of TIPS outstanding. We find direct evidence that the mispricing narrows as additional capital flows into the markets. This provides strong support for the slow-moving-capital explanation of the persistence of arbitrage

YiLi Chien, Hal Cole and Hanno Lustig (2012), Is the Volatility of the Market Price of Risk due to Intermittent Portfolio Rebalancing? American Economic Review, forthcoming[Link]Winner of Nasdaq Award at WFA in Vancouver.

Abstract: Our paper examines whether the well-documented failure of unsophisticated investors to rebalance their portfolios can help to explain the enormous counter-cyclical volatility of aggregate risk compensation in financial markets. To answer this question, we set up a model in which CRRA-utility investors have heterogeneous trading technologies. In our model, a large mass of investors do not re-balance their portfolio shares in response to aggregate shocks, while a smaller mass of active investors adjust their portfolio each period to respond to changes in the investment opportunity set. We find that these intermittent re-balancers more than double the effect of aggregate shocks on the time variation in risk premia by forcing active traders to sell more shares in good times and buy more shares in bad times (Program Code for `Intermittent Rebalancing')

Abstract: We develop a method for identifying and quantifying the fiscal channels that help finance government spending shocks. We define fiscal shocks as surprises in defense spending and show that they are more precisely identified when defense stock data are used in addition to aggregate macroeconomic data. Our results show that in the postwar period, about 9 percent of the US government's unanticipated spending needs were financed by a reduction in the market value of debt and more than 70 percent by an increase in primary surpluses. Additionally, we find that long-term debt is more effective at absorbing fiscal risk than short-term debt.

Abstract: We identify a “slope” factor in exchange rates. High interest rate currencies load more on this slope factor than low interest rate currencies. This factor accounts for most of the cross-sectional variation in average excess returns between high and low interest rate currencies. A standard, no-arbitrage model of interest rates with two factors—a country-specific factor and a global factor—can replicate these findings, provided there is sufficient heterogeneity in exposure to global or common innovations. We show that our slope factor identifies these common shocks, and we provide empirical evidence that it is related to changes in global equity market volatility. By investing in high interest rate currencies and borrowing in low interest rate currencies, U.S. investors load up on global risk.

Abstract: Our paper examines the impact of heterogeneous trading technologies for households on asset prices and the distribution of wealth. We distinguish between passive traders who hold fixed portfolios of stocks and bonds, and active traders who adjust their portfolios to changes in expected returns. To solve the model, we derive an optimal consumption sharing rule that does not depend on the trading technology, and we derive an aggregation result for state prices. This allows us to solve for equilibrium prices and allocations without having to search for market clearing prices in each asset market separately. We show that the fraction of total wealth held by active traders, not the fraction held by all participants, is critical for asset prices because only these traders respond to variation in state prices and hence absorb the residual aggregate risk created by non-participants. We calibrate the heterogeneity in trading technologies to match the equity premium and the risk-free rate. The calibrated model reproduces the skewness and kurtosis of the wealth distribution in the data. In contrast to existing asset pricing models with heterogeneous agents, our model matches the high volatility of returns and the low volatility of the risk-free rate. (Program Code for `A Multiplier Approach')

Abstract: Three of the most fundamental changes in US corporations since the early 1970s have been (1) the increased importance of organizational capital in production, (2) the increase in managerial income inequality and pay-performance sensitivity, and (3) the secular decrease in labor market reallocation. Our paper develops a simple explanation for these changes: a shift in the composition of productivity growth away from vintage-specific to general growth. This shift has stimulated the accumulation of organizational capital in existing firms and reduced the need for reallocating workers to new firms. We characterize the optimal managerial compensation contract when firms accumulate organizational capital but risk-averse managers cannot commit to staying with the firm. A calibrated version of the model reproduces the increase in managerial compensation inequality and the increased sensitivity of pay to performance in the data over the last three decades. This increased sensitivity of compensation to performance provides large, successful firms with the glue to retain their managers and the organizational capital embedded in them.

Dirk Krueger and Hanno Lustig. (January 2010). When is Market Incompleteness Irrelevant for the Price of Aggregate Risk (and when is it not)?.Journal of Economic Theory,[Link]

Abstract: In a standard incomplete markets model with a continuum of households that have constant relative risk aversion (CRRA) preferences, the absence of insurance markets for idiosyncratic labor income risk has no effect on the premium for aggregate risk if the distribution of idiosyncratic risk is independent of aggregate shocks and aggregate consumption growth is independent over time. In equilibrium, households only use the stock market to smooth consumption; the bond market is inoperative. Furthermore, the cross-sectional distributions of wealth and consumption are not affected by aggregate shocks. These results hold regardless of the persistence of idiosyncratic shocks, even when households face tight solvency constraints. A weaker irrelevance result survives when we allow for predictability in aggregate consumption growth.

Abstract: We construct a new data set of consumption and income data for the largest US metropolitan areas, and we show that the extent of risk-sharing between regions varies substantially over time. In times when US housing collateral is scarce nationally, regional consumption is about twice as sensitive to income shocks. We also document higher sensitivity in regions with lower housing collateral. Household-level borrowing frictions can explain this new stylized fact. When the value of housing relative to human wealth falls, loan collateral shrinks, borrowing (risk-sharing) declines, and the sensitivity of consumption to income increases. Our model aggregates heterogeneous, borrowing-constrained households into regions characterized by a common housing market. The resulting regional consumption patterns quantitatively match those in the data.

YiLi Chien and Hanno Lustig. (2009). The Market Price of Aggregate Risk and the Wealth Distribution.Review of Financial Studies,[Link]

Abstract: We introduce limited liability in a model with a continuum of ex ante identical agents who face aggregate and idiosyncratic income risk. These agents can trade a complete menu of contingent claims, but they cannot commit to honor their promises, and their shares in a Lucas tree serve as collateral to back up their state-contingent promises. The limited-liability option gives rise to a second risk factor, in addition to aggregate consumption growth risk. This liquidity risk is created by binding solvency constraints, and it is measured by the growth rate of one moment of the wealth distribution. The economy is said to experience a negative liquidity shock when this growth rate is high and a large fraction of agents faces severely binding solvency constraints. The adjustment to the Breeden-Lucas stochastic discount factor induces substantial time variation in equity risk-premiums that is consistent with the data at business cycle frequencies.

Abstract: Aggregate consumption growth risk explains why low interest rate currencies do not
appreciate as much as the interest rate differential and why high interest rate
currencies do not depreciate as much as the interest rate differential. Domestic
investors earn negative excess returns on low interest rate currency portfolios and
positive excess returns on high interest rate currency portfolios. Because high interest rate currencies depreciate on average when domestic consumption growth
is low and low interest rate currencies appreciate under the same conditions, low
interest rate currencies provide domestic investors with a hedge against domestic
aggregate consumption growth risk.

Hanno Lustig and Adrien Verdelhan. (2012). The Cross-Section of Foreign Currency Risk Premia and US Consumption Growth Risk: A Reply. American Economic Review,[Link]

Abstract: The consumption growth beta of an investment strategy that goes long in high interest rate currencies and short in low interest rate currencies is large and significant. Consumption risk price differs significantly from zero, even after accounting for the sampling uncertainty introduced by the estimation of the consumption betas. The constant in the regression of average returns on consumption betas is not significant. Additionally, this investment strategy's consumption and market betas increase during recessions and times of crisis, when risk prices are high, implying that the unconditional betas understate its riskiness.

Abstract: We analyze optimal fiscal and monetary policy in an economy with distortionary labor income taxes, nominal rigidities, nominal debt of various maturities and short-selling constraints. Optimal policy prescribes the almost exclusive use of long term debt. Such debt mitigates the distortions associated with hedging fiscal shocks by allowing the government to allocate them efficiently across states and periods.

Hanno Lustig and Stijn Van Nieuwerburgh. (2006). The Returns on
Human Wealth: Good News on Wall Street is Bad News on Main Street.Review of Financial Studies, [Link]

Abstract: We use a standard single-agent model to conduct a simple consumption
growth accounting exercise. Consumption growth is driven
by news about current and expected future returns
on the market portfolio. We impute the residual of consumption growth
innovations
that cannot be attributed to either news about
financial asset returns or future labor income growth to news about
expected
future returns on human wealth, and we back out the
implied human wealth and market return process. Innovations in current
and future human wealth returns are negatively correlated with innovations in current and future financial asset returns, regardless of the elasticity of intertemporal
substitution.

Abstract: In a model with housing collateral, the ratio of housing wealth to human wealth shifts the conditional distribution of asset prices and consumption growth. A decrease in house prices reduces the collateral value of housing, increases household exposure to idiosyncratic risk, and increases the conditional market price of risk. Using aggregate data for the United States, we find that a decrease in the ratio of housing wealth to human wealth predicts higher returns on stocks. Conditional on this ratio, the covariance of returns with aggregate risk factors explains 80% of the cross-sectional variation in annual size and book-to-market portfolio returns.